(This article originally appeared in the New York Law Journal)

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NEW YORK CITY-Energy independence is a major American policygoal, and the Internal Revenue Code has not been neglected in thatpush. There are tax credits for the manufacturing of "greentech"equipment and for purchases of energy-efficient appliances. Taxcredits are available for business and homeowner purchases ofproperties that generate renewable energy. A tax credit can beclaimed for each kilowatt-hour of electricity from variousrenewable energy sources. This article will focus on the businesstax credit for purchases of solar panels and other solar energyproperty, an area of growing interest to commercial rental propertyowners. In lieu of the tax credit, property owners for a limitedtime can claim a grant equal to the amount of the credit, withfewer restrictions.

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Credits
The energy tax credit in Code section 48 is equal to 30% of thebasis of purchased solar energy property used in the United Statesin a trade or business or income-producing activity. Solar energyproperty includes assets that use solar energy to generateelectricity, or to heat or cool a structure, as well as solar waterheaters and "equipment which uses solar energy to illuminate theinside of a structure using fiber-optic distributed sunlight." Thecredit rate drops to 10% for solar energy property placed inservice after Jan. 1, 2017. The basis of the energy property isreduced by half of the amount of any credit claimed on theproperty.

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The landlord of an office building may install solar panels onthe building, claim the credit, and sell the electricity to thetenants. For example, if the landlord spends $200,000 on the solarpanels, it can claim a tax credit of $60,000, which would reducethe basis in the solar panels by half the credit amount to$170,000. Since solar panels, like most energy property, aredepreciated over a five-year period, the landlord can claim $34,000of depreciation deductions in the first year (20% of the $170,000basis).1 If the property is disposed of during the five-yearperiod, a gradually decreasing portion of the tax credit isrecaptured and added to the landlord's tax liability. For example,$48,000 (80% of the tax credit) is recaptured if the landlord wereto sell all the solar panels in year two. Furthermore, the basisreduction caused by the credit, as well as the cumulativedepreciation, may be recaptured as ordinary income.

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Many hurdles must be overcome in order to qualify for the taxcredits. Individuals and certain other taxpayers are subject to thetax credit "at-risk" rules in Code section 49, which reduces theamount of the credit if the wrong sources of financing areused.

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Even if the credits are not limited by the "at-risk" rules,other Code provisions may limit the landlord's ability to use thecredits. For example, the landlord may be subject to the passiveactivity rules, since a rental business is almost always a passiveactivity. Losses and tax credits from passive activities cannotreduce the tax on active business income or portfolio income (suchas interest and dividends). Rental real estate activity may becomenonpassive only if the landlord materially participates in theactivity and the landlord is a "real estate professional."

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In addition, the $60,000 of nonrefundable solar tax credits areuseful only if our hypothetical landlord has positive taxliability, though in some situations a lessor may elect to pass thecredit to a lessee of the solar energy property. A 2008 change inthe law now allows the energy tax credit to offset 100 percent ofalternative minimum tax liability. A further limitation is thatgeneral business credits (such as the energy tax credit) cannotreduce a taxpayer's total tax liability below 25% of the taxpayer'sregular income tax liability in excess of the first $25,000 (the"25%-of-tax limitation"). For example, if the landlord has $45,000of regular tax liability, it may use only $40,000 of generalbusiness credits to reduce its taxes to $5,000 (25% of the excessof $45,000 over $25,000). The unused credits may be carried backone year and forward 20 years.

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Grants
Taxpayers are effectively freed of many of the above rules thanksto the American Recovery and Reinvestment Act of 2009, whichauthorized "section 1603 grants" from the Treasury Department forenergy property placed in service in 2009 or 2010 that is otherwiseeligible for the energy tax credit. The grant is also available toenergy property for which construction began in 2009 or 2010 if theproperty will ultimately be placed in service before Jan. 1, 2017.The section 1603 grants and the energy tax credits are exactlyequivalent in amount, and they cannot both be claimed for the sameproperty. The grant for solar energy property is tax-free incomeequal to 30% of the property's basis, and the basis is then reducedby half the grant amount. The original intention of the section1603 grant program was to make funding available sooner forrenewable energy projects, by requiring payment within 60 daysafter the property is placed in service.2 But unlike thenonrefundable energy tax credit, the grant is not limited by thepassive activity rules or the 25%-of-tax limitation.

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The section 1603 grant has some limitations. It is subject tothe same "at-risk" and recapture rules applicable to the energy taxcredit. Governments and tax-exempt entities cannot claim the grant.If a tax-exempt entity is a partner in a partnership, thatpartnership cannot claim the grant at all. In contrast, taxablepartners may claim their pass-through share of the energy taxcredit for the partnership's energy property even when there aretax-exempt partners in the partnership.

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REITs are subject to special restrictions under both the energytax credit and the section 1603 grant. If a REIT reduces itstaxable income to zero with the dividends-paid deduction bydistributing all of its income to shareholders, it cannot claim anyenergy tax credits or section 1603 grants.

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The section 1603 grant program will expire Jan. 1, 2011.Although legislation proposed in February 2010 would extend thegrant deadline to Jan. 1, 2013, the bill is still in committee andmight not be enacted.3 So time is running out for commercial realestate owners to take advantage of a government incentive that isfar less restrictive than is usually the case.

  1. It is assumed that the property is depreciated using thehalf-year convention and the 200% declining balance depreciationmethod.
  2. Or 60 days after the grant application date if later than theplaced-in-service date.
  3. The proposed legislation (H.R. 4599) would also eliminate thegrant restrictions for REITs and permit partnerships withtax-exempt partners to claim a pro rata amount of the grant.

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